MagicDiligence (< 20)

MFI Stock Review: Nathan's Famous (NATH)

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Think back to the summer. Every backyard barbecue comes with at least 2 staples: hamburgers and hot dogs. So why is it, that when you drive into town for fast food, you can find half a dozen burger joints but are lucky to find one that serves a decent hot dog? I had never really thought much about this before looking into Magic Formula small-cap Nathan's Famous (NATH).

When you think about it, Nathan's largely owns the quick-service hot dog niche. The company is well-known even outside of its native metropolitan New York home territory, thanks largely to the Nathan's Famous Hot Dog eating contest broadcast every year on ESPN (DIS) from Coney Island. Try typing "hot dogs" into Google (GOOG) - the second hit is Nathan's website (after Wikipedia, naturally)! This brand recognition has allowed management to pursue a markedly different strategy from most competing fast-food chains.

Nathan's has 3 types of business. First are the restaurants and carry-out locations. At the end of September, there were about 175 franchised units, and 7 company-owned locations. Obviously, the company-owned restaurants operate as typical retail stores, while franchisees pay an up-front fee and about 5.5% of store sales back to the company.

The second business is selling branded product to 3rd party food-service operators. Nathan's has two distinct programs in this vein. The first, which they call "Branded Product", allows operators to use the Nathan's name and branding to sell hot dogs at their locations. The second, called "Branded Menu", is in effect an expanded version, where certain operators can provide an entire Nathan's menu in what amounts to almost a co-branding arrangement (similar to Yum Brand's - YUM - Taco Bell/KFC stores). In both programs, the company earns revenues by selling product either directly or through an approved distributor to the 3rd party operator, pocketing a markup on the food costs. There are over 13,000 points of sale that sell Nathan's Famous branded products, including Auntie Anne's, Subway, Yankee Stadium, vending machines, etc. The Branded Menu program has only one customer right now.

Finally, the company licenses the brand for selling franks at supermarkets in 39 states.

How does this company stack up in the 3 requirements of growth potential, competitive advantage, and financial strength? Let's cross one off the list immediately - NATH is in great financial shape. The company has close to $35 million in cash (nearly half of market cap), and no debt. With primarily a branding, licensing, and franchising business, capital requirements are very low, meaning both free cash flow (10% FCF margin) and return on capital (44% standard, 95% MFI) are both outstanding. Financial health is a solid A.

The other two are a bit less straightforward. Nathan's has had lukewarm revenue growth for the past 5 years, a CAGR of just over 7%. However, operations have improved, and operating earnings have compounded at near 15% a year, which is solid. Pushing forward, the focus seems to be on expanding the 3rd party operation into more distributors. I like this strategy. Franchising is risky and requires a lot of stores to be successful. Selling branded product in the supermarket puts you up against other strong store-based brands. But as mentioned earlier, there are not many fast-food hot dog brands to compete with, and the higher prices a Nathan's dog commands is attractive to those looking to diversify their menus. While I expect some success with the program, it will still be difficult for the company to drive more than 7-8% sales growth annually - not bad but nothing too exciting. Operating margins are already good and will be difficult to expand significantly.

Competitively, well, it doesn't take an analyst to tell you how crowded and competitive quick service restaurants are. Price wars are constantly breaking out, competitors like McDonald's (MCD) and Yum! have tremendous scale, brand knowledge, and marketing resources. There is competition literally at every corner of every town. Nathan's one advantage is the relative dearth of hot dog branding in food service. It can charge higher prices because of it, something competitors cannot do with a generic dog.

Valuation is cheap - both the trailing and forward earnings yield is 15.5%. This makes NATH a good valuation play. Considering both McDonald's and Yum trade at about 7-8% earnings yield, there is at least 4-5 percentage points of potential (small caps usually trade cheaper, justifiably). Add that to Nathan's modest operational growth and continuing share buybacks and you can start to see the potential for solid gains. It doesn't have the chops to make the MagicDiligence Top Buys list, but Nathan's Famous is a solid MFI pick nonetheless.

At $14, it is probably undervalued, but not quite undervalued enough to get me all that interested. Playing a bit on the conservative side, I'd go with a valuation around $20 - $25. I'd veer closer to $20 for the OCF-to-earnings issue. Not bad, but I'd have to believe there were growth possibilities or collect a dividend to be enticed at $14+. Also, the large number of insider sells doesn't give me any additional confidence in it.